Factors in Investing… Last month we explored the investment factor, Safety. This month I would like to explore Value, the most important investment factor. Throughout history, value has played an important part in all transactions. It was with Benjamin Graham in the 1930s that value became — and remains — the most important investment factor. Graham suggested that investors use companies’ assets less liabilities as the main investment factor. This is generally called book value, which is the birth of the term Value Investing. Price/Book (P/B) is the principal formula. A second major approach to measuring value is Price/Earnings or P/E. In both formulas, lower numbers are better. The price of the security is not difficult to determine. However, Book Value and Earnings are subject to interpretation. (Some would say manipulation.) Extensive regulations by both the accounting profession and government regulators have reduced but not eliminated this problem. As far back as the nineteenth century, this problem was recognized, as you can see from the following quotation: “Earnings are a theory, cash is a fact.”

To get a more comfortable view on value, some analysts, including ourselves, use an alternative measure of value called Free Cash Flow as their primary data point. Free Cash Flow is the cash left over from sales after paying all corporate expenses except dividends and funds used to reduce shares outstanding. Essentially, this is the money left over for shareholders. This definition explains why Free Cash Flow is sometimes called Shareholder Earnings. Free Cash Flow is widely used as a non-primary factor in security analysis but is the primary factor in real estate value analysis. The formula used is different from the P/B and P/E in that it is Free Cash Flow/Price or FCF/P, and therefore the higher the number the better.

What makes Value so important is that it should be used in almost all security analysis. The market is generally divided into Value stocks and Growth stocks. The Value factor is obviously used to put together Value portfolios. It is also a major factor in putting together Growth portfolios. Most Growth portfolios are based on some form of “growth at a reasonable price.” All else being equal, the Growth company with twice the Free Cash Flow is clearly more attractive.

How do we use Value in our portfolios? We insist that all securities meet Value criteria that would put them in Value funds. But we also insist that all securities meet Growth criteria that would put them in Growth portfolios — a unique combination that few but hopefully exceptional securities can meet.

Sincerely,

Katz Family Financial